By Gertrude Chavez-Dreyfuss
NEW YORK (Reuters) - Recession worries are sending investors into Treasuries and other fixed income investments ahead of the Federal Reserve's first meeting of 2023, even as stocks start the year with a hopeful rally. Yields on the benchmark U.S. 10-year Treasury note, which move inversely to prices, have fallen by around 83 basis points from their October high of 4.338% and investors sent $4.89 billion into U.S. bond funds last week, the third straight week of net inflows. The rally comes after Treasuries notched the worst year in their history following the Fed's most aggressive monetary policy tightening since the 1980s. Worries that the Fed's rate increases will send the U.S. economy into a recession have been a key driver of demand for Treasuries, often seen as a safe haven during economically uncertain times. While investors widely expect the Fed to raise rates by another 25 basis points at the end of its monetary policy meeting on Feb. 1, markets are also looking for signals that the central bank is pulling back on its hawkish monetary policy amid signs of falling inflation and softness in the economy.
"Things are coming off the boil here," said Rob Daly, director of fixed income at Glenmede Investment Management. "There is a de-risking that's happening, and we're seeing flows out of equities into higher quality parts of the market such as fixed income." That move has stood in contrast to a recent rally in stocks, where recession concerns are less apparent and hopes of a so-called soft landing, where inflation eases and growth remains resilient, have emerged.
The S&P 500 has risen 4.6% year-to-date and the Nasdaq Composite is up nearly 9% in a rebound that has lifted many of the names that were beaten down in last year’s equity rout.
Some equity investors are nevertheless playing it safe, expecting the current rally in stocks to wilt if a recession hits. U.S. equity funds have witnessed outflows for ten straight weeks, even as indexes charge higher, with investors pulling some $1.14 billion in the latest week, according to Refinitiv Lipper data. Phil Orlando, chief equity strategist at Federated Hermes, is sitting in Treasuries, cash and other defensive investments in anticipation of a reversal in the current rally in stocks. "Our sense is that stocks are (going)lower and we need to maintain a defensive posture," he said.
The Fed has projected it will raise its key policy rate to between 5% and 5.25% and keep it there at least until the end of the year, an outlook many investors fear will make a recession all but inevitable or exacerbate an economic downturn. The rate currently stands between 4.25% and 4.50%. For now, many investors are wedded to a more dovish view, betting that policymakers will blink if growth starts to slow. Futures markets show expectations of rates peaking at around 4.93% and falling in the latter half of the year.
Solidifying expectations of a more dovish Fed would, in theory, cap views for how high rates will rise and bolster the case for bond yields to move lower.
"My bet is on a recession," said Ellis Phifer, managing director, fixed income research, at Raymond James. "The Fed is closer to the end than the beginning, and rates usually fall across the curve when the Fed is finished raising rates."
Of course, some investors are happy to take the central bank at its word and are betting rates stay higher for longer.
BlackRock, the world's largest asset manager, wrote on Monday it believes the disconnect will resolve in favor of higher rates, as global central banks "overtighten policy because they're worried about the persistence of underlying core inflation."
Strategists at the firm recommended short-term government bonds, high-grade credit and agency mortgage-backed securities.
Recessions are typically called in hindsight by the National Bureau of Economic Research (NBER) and few investors believe the U.S. economy is currently experiencing one. Yet weaker consumer spending, a drop in manufacturing activity, and layoffs in the technology industry have been cited as evidence of a looming downturn. Bruno Braizinha, director, U.S. rates strategy at BofA Securities in New York, said he has seen a pick-up in demand for Treasuries, reflecting "a more cautious view for the outlook." BofA's core view is a recession in the second half with job losses as well, he added. "So I don't find it unreasonable that the market is pricing cuts in late-2023."
(Reporting by Gertrude Chavez-Dreyfuss; Editing by Ira Iosebashvili and Nick Zieminski)